How Debt Consolidation Loans Work, Step by Step
What consolidation does and doesn't do, the main ways to consolidate, and a worked example of the costs.
In this guide
Key takeaways
- Consolidation combines several debts into one payment. It doesn't reduce what you owe.
- It saves money only if the new rate and fees cost less than your current debts.
- A longer term can lower the monthly payment but raise the total cost.
- Be careful with debt settlement companies that advertise as consolidation services.
Introduction
If you're paying several credit cards or loans each month, combining them into one payment can make life simpler. That's what debt consolidation does. Done well, it can also lower the interest you pay. Done badly, it can cost more and leave you with more debt than before.
This guide explains how consolidation works, the main options, what it costs and the warning signs to watch for.
Advertisement
What debt consolidation means
Debt consolidation means rolling several debts into a new loan or account, so you make one payment instead of many. The Consumer Financial Protection Bureau points out that a consolidation loan doesn't erase your debt. It just combines it.
Whether you save money depends on three things: the interest rate on the new debt, any fees, and how long you take to repay it.
The main ways to consolidate
1. A debt consolidation loan
Banks, credit unions and online lenders offer personal loans for consolidation. You use the loan to pay off your cards or other debts, then repay the loan in fixed monthly payments over a set term.
2. A balance transfer credit card
A balance transfer card lets you move card balances onto one card, often with a low or 0% promotional rate for a set time. There's usually a transfer fee, and the rate rises when the promotion ends. See our guide: How Balance Transfer Cards Work.
3. A home equity loan or line of credit
These use your home as security, so rates can be lower. But the CFPB warns that using a home equity loan to consolidate card debt is risky: if you can't repay it, you could lose your home. There may also be closing costs.
4. A debt management plan
A nonprofit credit counseling agency can set up a plan where you make one monthly payment to the agency, which pays your creditors. The agency may be able to arrange lower interest rates or waived fees. There's usually a small monthly fee.
6 more sections · 8 min read
Continue reading this guide
Watch a short ad to read the rest of this guide. You'll only need to do this once for this guide.
Not now, show me another guide →A worked example
Here's how the numbers can compare. The figures are rounded and for illustration only.
The situation: $15,000 spread across three credit cards, averaging 22% APR.
| Keep paying the cards | 4-year loan at 12% | 5-year loan at 12% | |
|---|---|---|---|
| Monthly payment | $395 | About $395 | About $334 |
| Time to pay off | About 66 months | 48 months | 60 months |
| Total interest | About $10,900 | About $3,960 | About $5,020 |
In this example, the 4-year loan saves about $6,900 in interest compared with the cards. The 5-year loan has a lower monthly payment, but costs about $1,060 more in interest than the 4-year loan because you're paying for longer.
Any origination fee would add to the loan's cost, so include it when you compare.
Step by step: consolidating with a loan
- List every debt with its balance, interest rate, minimum payment and any payoff penalties.
- Check your credit reports for errors. Your credit affects the rate you'll be offered.
- Work out what you can afford each month, and how long you'd need to clear the debt.
- Compare offers from several lenders, including your bank or credit union. Many let you check your rate with a soft credit check.
- Compare the total cost, not just the monthly payment: APR, origination fee and the total amount repaid.
- Pay off the old debts. Some lenders pay your creditors directly. If the money comes to you, pay the debts straight away.
- Confirm each account shows a zero balance, and keep paying the old accounts until it does.
- Set up automatic payments for the new loan so you never miss one.
Advertisement
When consolidation may not help
- The new rate isn't lower. If your credit has been affected by debt problems, you may not qualify for a rate that saves money.
- Spending continues. The CFPB notes that consolidation probably won't help if you're spending more than you earn, unless you cut spending or increase income. Clearing cards with a loan and then running them up again leaves you with more debt.
- The term is much longer. A lower monthly payment over more years can cost more overall.
- Promotional rates end. Some low rates are temporary and rise later.
Consolidation vs debt settlement
Some companies that advertise "consolidation" are actually debt settlement companies. They may tell you to stop paying your creditors and pay into a special account instead, then try to negotiate a smaller payoff.
The CFPB warns that debt settlement can damage your credit, lead to collection activity or lawsuits, and add late fees and interest while you're not paying. It also warns against any company that charges fees before settling your debts, guarantees it can make your debt go away, or tells you to stop communicating with your creditors.
Before you sign anything, ask exactly what the company will do: give you a loan, set up a debt management plan, or negotiate settlements.
Advertisement
Other options to try first
- Call your creditors. Some may lower your payment, reduce your rate, waive fees or move your due date to match payday.
- Make a budget to see whether you can pay the debts faster by adjusting spending for a while.
- Talk to a nonprofit credit counselor, who can review your situation and explain your options.
Conclusion
Debt consolidation can simplify your payments and, with a lower rate, reduce what you pay in interest. But it doesn't reduce the debt itself, and a longer term or new spending can wipe out the savings. Compare the total cost of each option, avoid anyone who asks for fees upfront or promises to make debt disappear, and choose a plan you can stick to.
Common questions
Does debt consolidation hurt your credit?
Applying usually causes a small, temporary dip from a hard inquiry. Over time, on-time payments and lower card balances can help your credit.
Can I consolidate debt with bad credit?
It may be harder to qualify for a rate that saves money. A nonprofit credit counselor can explain other options, such as a debt management plan.
Should I close my credit cards after consolidating?
Not necessarily. Closing cards can affect your credit use and history. Many people keep them open with a zero balance but stop using them.
Sources and further reading
This guide is general information, not financial advice. Rates, fees and terms vary by provider and can change. Always check the provider's own terms, and consider speaking to a qualified financial professional about your situation.
